March 7, 2022
When the Russian army gradually invaded the south of Ukraine, the oil price exceeded 115$ for WTI and 120$ for Brent last week, a range that accumulated a large short position which eventually covered and even took the opposite long direction. This could finally lead to a further surge in oil prices and a short-term overbought market. Euro Area PPI spiked to 30.6%, a fresh record in January this year.
The United States announced the release of 60 million barrels of crude oil, which is only 3 to 4 days of consumption in the United States, and wartime is likely to consume more oil. The crude oil inventory data showed such release was far below market estimates, and crude oil futures logically entered a super backwardation, indicating that traders have no confidence in the short-term market supply.
In fact, not only crude oil futures, but other major commodity futures have also begun to show a similar backwardation structure. Since looking ahead to 2022 last January, I have been emphasising the strength of commodities as we are approaching the end of another long-term cycle. If anyone has any illusions about the current strength of crude oil and commodities — it must be a Fed official.
Here is the deja vu: In 1973, Egypt wanted to regain the Golan and Sinai territories lost in the “Six-Day War”, and took advantage of the “Yom Kippur” Jewish holiday to raid Israel. After the holiday, the Israeli army turned to the United States for help and overwhelmingly defeated Egypt at the end. To settle the situation, Nixon applied to Congress for funding assistance to Israel, but deliberately delayed the application by a week. Nixon’s move was to secretly reserve time for Egypt, and he also hoped to give the United States a chance to step down from the tension. Of course, this is yet another move by the United States to interfere with the geopolitical pattern: on the surface, both Israel and Egypt had to compromise, but it also lays the groundwork for more conflicts in the future.
Not surprisingly, the Arab countries did not appreciate it. When the oil embargo began, the oil price quintupled from 2$ to 10$ and finally hit 12$. The great stagflation in the United States began. After the Iranian Revolution in 1979, oil prices doubled again, until Volcker was in danger and turned the tide.
At the moment, the dollar is appreciating, U.S. Treasury yields are falling, and safe-haven asset prices are rising, all of which seem to conflict against the strength in crude oil and commodities. Some Fed officials also believe that inflationary pressures will not continue. Who buys bonds when there is inflation? If the bond traders still see a 10yr yield below 2%, then why would the Fed worry about it, although we also observed a 2yr spike from 0.137% to 1.488% over last year.
However, there is another side of the story:
After announcing sanctions on Russia’s dollar payment system, the U.S deliberately excluded energy transactions from the scope of the sanctions, although at the same time it repeatedly stated that “Russian crude oil is ultimately no exception.” Of course, the last card could be to freeze the overseas US dollar reserves and assets of the Russian central bank and prohibit the Russian central bank from providing liquidity to sanctioned Russian banks. SBER Bank, one of Russia’s major banks and listed in London, plunged to just one penny last week. The US dollar hegemony sanctions have indeed severely impacted the Russian financial system in the short term, but it might lead to a backlash.
Excluding Russia from the U.S. dollar payment system and freezing the U.S. central bank’s U.S. dollar assets is actually a demonstration that U.S. dollar assets are not so-called “safe assets’’. Your assets are safe only if the United States recognizes your dollar assets. In the short term, such sanctions will encourage the global risky assets setting offshore to rush back to onshore USDollar, especially emerging market countries. This happened at every end of the easing cycle. However, after recognizing this hegemonic rule of the dollar system, which country has not begun to develop a payment system independent of the dollar, at least China does. They created CIPS to replace CHIPS, and digital Reminbi system to replace SWIFT. The continuous strengthening of the renminbi is just like a sign that reflects the weakness of the US dollar system.
Historically, every oil crisis or spike in oil prices has been followed by a recession in the U.S. without exception. Today, oil prices are soaring once in nearly 50 years. The last time we saw oil prices soar to such heights in such a short time window was the 1973 oil crisis.
The Bretton Woods system collapsed before the first oil crisis, creating a new global monetary system. Once, oil was priced in gold. After the bankruptcy of the Bretton Woods system, Kissinger brought to the world the petrodollar system that established the hegemony of the dollar. At that time, if the oil was priced in gold, it could have been as high as more than 400 USD a barrel. The German government bond fell more than 20 points in a single day for the third time in more than three decades, as Germany announced a massive increase in military spending. At the same time, the change in the one-day implied volatility of treasury bonds has reached five times the variance — that is, the probability is 0.000002857%.
A new monetary system is on the way, about to break out of its shell. In fact, it is necessary for countries kicked out of the dollar system to return to the gold anchor. If Russia’s currency was priced in gold instead of dollars, the ruble would probably be way below 144USD.
What we can be certain about in this war is that the turmoil in the crude oil market will continue in the short term. With uncertainty over whether the sanctions will cover energy. Each financial institution has to exhaust the legal citations when providing credit lines to refiners. This situation is bound to further shrink oil supply in the short term. Some oil traders have seen 185–200 USD targets before they will turn to short again.
Today, U.S. real yields have plummeted to their lowest levels since the last 20 years. Such scenes have only been seen during the two oil crises in 1970s and 1980s, and both times, US stagflation, economic recession, and the sell off in both stocks and debts happened. Most of the market analysts right now haven’t lived such long lives to experience the full-cycle.
That is, every oil crisis or spike in oil prices is accompanied by a reshaping of the monetary system: the petrodollar in 1973, the Volcker in 1980, and quantitative easing in 2008. This time it should be no different. At one point, Volcker’s former Fed chairman Arthur Burns eloquently discussed why monetary policy could not solve inflation caused by structural problems such as war, and deliberately excluded oil and food prices from inflation calculations. That’s also probably why the current inflation is only “capped” at 7.5%.
Last year, the very popular “Modern Monetary Theory” was arguing that no matter how much the Fed printed money, inflation would be hard to pick up. Thinking about it, the core of this theory assumed continuation of US dollar credit and US dollar hegemony. However, if the inflation in the United States is calculated according to the original inflation calculation method before the 1970s, the CPI in the United States is now 15%, not 7.5%. When considering the two sides of the balance sheet: the Fed’s liabilities are the appreciation of US assets, Modern Monetary Theory fails to take into account that, without credit, asset prices are just inflated. Printing money simply adds zeros to the price of the asset, yet nothing changes in the value of the cash flow generated by the asset.
Macro changes are always silent and difficult to see, but in the end they come as groundbreaking shocks — just like the melting of glaciers and the final avalanche. At the turning point, which currency will dominate the world? Overall, it sounds like a positive signal of cryptocurrency, though we cannot ignore that the Fed is also ready to protect the hegemony of USD: last Friday, when senator Shelby asked Powell: “is the leadership of the Fed under you and the Fed prepared to do what it takes to get inflation under control and protect price stability” and Powell’s answer was “Yes”.
